It's Adverse. But Is It Selection?

By Megan McArdle

I'm afraid we're all just going to have to adjust to the fact that it's going to be All Healthcare, All the Time until the August recess.

So: onto adverse selection.

Adverse selection is the idea that information asymmetries in markets can lead to sub-optimal outcomes. Say 30% of all used cars are lemons that will cost you a fortune to repair. A new car is worth $10,000 while a good used car is worth $5,000, but a lemon is only worth $1,000, because of the repairs.

The problem is, you can't tell which cars are lemons. So you won't be willing to pay $5,000. You might be willing to pay more like $3,500, which compensates you for the risk. But the owners of the good cars will not wish to sell them at such a steep discount. The owners of the crap cars, however, will leap at the chance to unload them for such a great price. The percentage of lemons in the market goes up to 50%. You demand a bigger discount to compensate you for the higher risk; now you'll only pay $2,500. More owners of high-quality used cars decide to keep them rather than buy a new one. The percentage of lemons rises to 70% . . .

You can see where this is going. And, presumably, how it might apply to insurance markets: you end up with a pool of very sick people who cost a lot to cover. This (along with a lavish schedule of mandatory benefits) is arguably why health insurance in New York State costs so much.

Adverse selection is a favorite explanation of why markets for health care can't work, and health care therefore needs to be provided by the government. Often, the proponents of this theory add a wrinkle: insurance companies spend huge amounts of money on trying to keep from treating people.

If insurance companies do avoid covering people who are
"likely to need care," this suggests that the uninsured are
unhealthy. But 60% of the uninsured are in excellent health
(Table 10) (In fact, overall the uninsured are only slightly less healthy than the insured).

But the statement '[Insurance companies] try to avoid covering people
who are actually likely to need care' very obviously does not imply the
statement 'All uninsured people are being refused coverage because they
have expensive conditions.' The logical connection between the two
implied by the 'contra Paul' bit is not, to put it mildly, clear to me.
As a result, I am not sure what Alex's actual point is. Is he
suggesting that the incentive problems that Paul identifies are in some
sense unimportant?

But on reflection, I think Henry and I were wrong. I was very surprised to follow through to the table Alex Tabarrok links (from the Kaiser foundation, hardly a right-wing advocacy group) and find out that the percentage of the uninsured* who are in "fair" or "poor" health really isn't much larger than the percentage of the insured in those categories: 10.3% of the uninsured, versus 8.4% of the insured.

That is surprising because we would expect the uninsured to be sicker than the general population, even if the insurance companies were doing nothing to weed out the sick. Being uninsured is correlated with other things that are strongly correlated with poor health: being born in another (poorer) country; being too sick to work full time; little education; low SES.

Of course, it's also true that the population of the uninsured is correlated with something that's also correlated with good health: being young. But then, this sort of undercuts the adverse selection argument, and also the moral imperative of giving them health insurance. If you could reasonably afford health insurance by dropping down to a lower-priced cell phone plan and cutting back on your bar tab, you are not a national emergency.

So for the nonce, let's ignore all those confounding factors, and assume that without virulent machinations by the insurance companies, the population of the uninsured ought to mirror the population of the insured in health status. How many people are being pushed out of the insurance market because of their poor health status? It can't be many; there are only 4.6 million people without health insurance who report poor or fair health status. And not all of those people are very sick. I'd be hard pressed to call my health better than fair because of my asthma and my Hashimoto's Thyroiditis. But neither of those diseases costs my insurance company, or me, much.

If there were no evil insurance companies involved, what would those percentages look like? A slightly higher percentage of the insured market would report fair health, and a slightly lower percentage of the uninsured market. But the difference would be less than 1 million people: 0.3% of the US non-elderly population, and 0.2% of the total population.

What this means is that even if this is a problem, it is not a big problem. You don't gut rehab the US health system because of a "market failure" affecting a small fraction of one percent of the population.

Of course, as Alex notes, that doesn't mean that uninsured sick people aren't a problem. But as both he and Tyler have pointed out, they seem more likely to be a distributional problem than a market failure. In other words, the problem is not that the market cannot provide them insurance; the problem is that they don't have the money to buy it.

This seems meaningless, a distinction without a difference, to most people. But in fact, distributional problems and market failures call for very different kinds of solutions. You fix distributional problems with cash or vouchers. You fix market failures with regulation or some other form of intervention.

Now, arguably, there could be a market failure that is being fixed by existing government interventions: regulations preventing insurance companies from ripping off customers; government programs to cover the indigent, which take care of those who have become too sick to work. But I have to agree with Alex; the empirical data does not seem to back up the notion that there is a large and persistent selection problem in current markets.